Elective Deferrals Before Adoption of 401(k)

[Guest smckinlay]

As a result of a determination letter application, the IRS is questioning a client about the timing of the adoption of its 401(k) plan. The client set up the plan effective 6/1/06 and allowed elective deferrals immediately at that time. They formally adopted the plan 12/1/06, under advice that the plan would be compliant if it was adopted before the end of the year.

I understand that under 1.401(k)-1(a)(3)(iii) of the regulations, elective deferrals are not permitted until the plan is adopted. This seems very clear, but, first question, is there any exception to this that we may be able to use? My research hasn't come up with anything remotely helpful.

Second, the employer may have other plans with the same problem that the IRS has not yet asked about. Are we able to bring those plans under VCP to avoid Audit CAP? I am assuming it would be considered an "operational failure".

Third, does anyone have any idea what kind of penalties are assessed for this type of qualification failure under CAP? I've never been through CAP before.

Thank you so much for any help!

[Bill Presson]

The client set up the plan effective 6/1/06 and allowed elective deferrals immediately at that time.

Can you explain this part in any more detail? What did they do to "set up the plan" at that time?

[Guest smckinlay]

The client set up the plan effective 6/1/06 and allowed elective deferrals immediately at that time.

Can you explain this part in any more detail? What did they do to "set up the plan" at that time?

Unfortunately, I wasn't around at the time, but I believe that was the date they actually set up the trust and started taking employee deferrals. Essentially, 6/1/06 was the date they started acting like the plan was in place and administering it under the terms they knew they would adopt. However, the plan document did not get formal board approval until December.

[QDROphile]

This is a matter of corporate governance, which typically neither the IRS nor HR management understand. If formal action were taken before the deferrals, including documentation, there is a very good chance that the plan was adopted with sufficient formality to meet requirements. While it is very clean and convenient to have board of director action that directly adopts the plan document, that is not the only way to adopt a plan. The IRS can be convinced of earlier adoption under appropriate circumstances with an intelligent explanation. Or the IRS can be beaten under the appropriate circumstances if the IRS limits its consideration to board action. It also appears that the employer did not have any appreciation for corporate governance and created a mess in the conflicting signals it created in the process.

[Guest smckinlay]

This is a matter of corporate governance, which typically neither the IRS nor HR management understand. If formal action were taken before the deferrals, including documentation, there is a very good chance that the plan was adopted with sufficient formality to meet requirements. While it is very clean and convenient to have board of director action that directly adopts the plan document, that is not the only way to adopt a plan. The IRS can be convinced of earlier adoption under appropriate circumstances with an intelligent explanation. Or the IRS can be beaten under the appropriate circumstances if the IRS limits its consideration to board action. It also appears that the employer did not have any appreciation for corporate governance and created a mess in the conflicting signals it created in the process.

Thank you, that may help. I will ask the company if there was anything that might have been evidence of a less formal adoption.

[QDROphile]

Frankly, I suggest that you involve legal counsel. The issue is not about "less formal." The issue is about who had authority with respect to adoption of the plan, what they did, and when. You are going to have be much more specific about what happened to "set up" and document the plan and the trust, and what was communicated to management and employees. You are going to have to look at how the employer is organized and the role and practices of the board and the officers and other agents in the employer's operations and employee compensation, including what the articles, bylaws and formal actions and policies say. Finally, someone has to sort out what happened and apply the correct context and terminology if you expect to convince the IRS. There is no room for more uncertaintly or confusion.

[Bill Presson]

QDROphile got back to this before I could, but that's the direction I was heading with my questions.

You've got a chance to pull this out, but you're definitely going to need legal assistance.

[rcline46]

We had a client start deferrals before they signed the amendment for the 401(k). The IRS audited and picked up on it. The agent was getting very testy about it. Then the agent realized two things: they would only hurt employees if they imposed a penalty, and the action happened outside of the the audit period! They could not impose any penalties.

So - the moral of the story is, what can they do? your dates indicate that this is outside of audit period, and then what penalty can the impose at this late date?